Pep Talk for Pension Reform

Viable, sensible, lasting solutions will require more efforts.

Girard Miller is the Public Money columnist for GOVERNING and a senior strategist at the PFM Group.

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Last month, three key episodes in the multi-year pension reform debates were front and center. First, a capital-markets analysis from the well-respected Barclays Capital research department. Barclays reported that the world is not ending and that public pension obligations — albeit under stress — are manageable in most states. Second, the Government Finance Officers Association (GFOA) held its annual national conference with prime-time sessions devoted to "dispelling myths about pensions" and properly chided the idea that we are at risk for an apocalyptic meltdown of the municipal bond market. Third, in the course of GFOA's pension presentations, the association approved the most informative "best practices" document yet produced by anybody — right, left or center.

The coincidental timing of these three events had the feel of a centrist pep rally at halftime in a scrappy football game. That should send us to the locker room to reflect on the progress made so far in resolving the serious funding problems facing public retirement systems.

It's now been three years since the Great Recession brought the spotlight to public pensions, as trustees collectively watched their trillion-dollar portfolios shrink to levels that could not themselves support the benefits promised to public employees. But it's also been 18 months since the economy turned the corner and equity markets rallied by 80 percent from their lowest levels. Moreover, for the past year or so, legislatures in 20 states have made earnest efforts to address their funding problems. Nonetheless, we have at least a dozen major pension funds that fail to fund properly on an actuarial basis and another bunch that cut corners with actuarial gimmicks or dubious assumptions. In addition, most retiree medical benefits are still funded on a pay-as-you-go basis with almost $2 trillion of unfunded liabilities nationwide. So let's take a breather here and think about (1) how far we've come from the abyss, (2) how far we still need to go, and (3) how to get to the promised land for stakeholders on all sides.

The Barclays Capital report, State Pensions: A Manageable Longer-term Challenge, provides some great statistics for those who seek hard data to clarify their analysis and arguments. They took an investors' view — not an ideologues' pulpit. Their objective observation is that some state plans are clearly in trouble, and many municipalities now face crushing budgetary costs to make rising pension contributions. These costs were brought on by excessive pension promises as well as the stock market losses of the public plans in the last recession. The analysts also note that although this will ultimately require workforce reductions over time, the dreaded-and-hyped outbreak of municipal bankruptcies predicted by some doomsayers is just not about to happen now or any time in the near future, if ever. The adjustment process will be long and painful for those who value public service and public services (and by those who resent higher taxes), but most municipal bondholders can sleep at night without worrying about their principal investments — at least as far as the risk that pension deficits will drive muni bond defaults any time soon.

It is important to note, however, that the long-term consequences of doing nothing to reform public pension plans and retiree medical benefits (aka OPEB, or "other post employment benefits") will mean a chronic erosion and demise of many state and local governments' ability to provide essential services. More reforms are needed in many states and localities where actions taken so far are either cosmetic or insufficient.

Thoughtful professional guidance. In this context, the GFOA has sensibly provided guidance to its thousands of professional members and their employers on how to address such issues as:

Sustainability of benefits: whether the employer and its taxpayers can actually afford to keep supporting current obligations without sacrificing basic public services that prevailed when these benefits promises were made.

Legal constraints and options: whether benefits promised to current employees can be modified prospectively, which depends on state laws and the language of written commitments made by the employer's legislative or governing body

Pension formula multipliers: some were premised on the fantasy that the stock market today would be worth twice its current level, and some are, in my view, too high to be justifiable in any light

Cost of living allowances for current and future retirees

Employee contribution levels, which are increasing significantly in many jurisdictions (and insufficiently in others, in my view)

Anti-spiking provisions, such as elimination of overtime and special pay in the pension base

Prohibition of retroactive benefits increases in the future, as a matter of policy.

By themselves, new benefit tiers won't solve the funding problems of some governmental employers, but they are a necessary starting place for most. As noted in my previous columns, new tiers for new employees do little to avoid service cutbacks in many jurisdictions because public employers are freezing payrolls to pay for pensions. Cutting ten percent of zero yields no savings. Pension reform in many localities will still require making adjustments to current employees' benefits for future service and charging them more whenever those benefits run well beyond local labor market levels in the real world.

As I reflect on progress along these fronts in the past year, public employee unions have impressed me by their willingness to step up to higher payroll contributions. Public employees are indeed sharing more of the burden of their benefits. I credit the unions in the city of Los Angeles for their landmark agreement to pay 4 percent of pay toward their retiree medical benefits. That's a big deal, and they deserve praise and sincere kudos from those of us in the passionate center of this debate. Where the unions have not surprised me was their traditional willingness to throw new hires under the bus by reducing benefits for future employees without, in most cases, biting the benefits bullet themselves. That's where the next round of pension reforms will come before this work is finished.

So here's my half-time locker-room speech to both sides:

The Great Recession has ended and governmental revenues will begin slowly to improve. States will see sales and income taxes recover slowly, but most municipalities must wait several more years before property taxes will join the recovery.

Few of these employers will enjoy sufficient revenue growth to bail out their pension costs and their unfunded OPEB plans, although the bleeding will slow. In this period of chronic austerity in the "new normal", public employees will be asked to make even more sacrifices in the years ahead, even as revenues trickle back to their employers. So it's now important to start the hard work to make these plans sustainable for the long run. Public managers and their state associations must lead the way.

Unions now need to move beyond the bargaining table to help public employers push through reform legislation in states where laws or court decisions currently block changes to incumbent employees' future benefit accruals. I know this will be ridiculed in some firehouses and union halls, but statutory changes must be made in these hamstrung states to allow collective bargaining to reduce future benefits accruals — if they are unsustainable and threaten the viability of the plan, especially if the employer declares or is declared to suffer financial distress that impairs its ability to meet those funding obligations and sustain vital public services. This statutory remedy should survive state constitutional and federal contract law challenges.

Several California cities (including Costa Mesa, Compton and San Jose) have already reached that fork in the road, and they are not alone. This kind of law would enable employees to bargain for pension and OPEB reductions in order to save their jobs and avoid pay cuts. Otherwise, public employers have little choice but to resort to layoffs, furloughs, five-year salary freezes and outsourcing as ways to cut payroll costs to "feed the pension dragon." Unions could audit and challenge the financial assessment, and nobody would be required to reduce future pension accruals, but at least they should have that option.

Likewise, the unions should support efforts by public employers to clarify state laws governing retiree medical (OPEB) benefits so that employees who make significant contributions are assured that their benefits are guaranteed (not merely a gratuity). However, the employer must first be allowed to change the benefit formula for current employees to something that taxpayers can actually afford to provide on an ongoing basis. San Diego's recent agreement would be a good example of how such a "new deal" for retiree medical benefits can be crafted by compromises on both sides.

If we could clear those two basic reforms through the state legislatures, there wouldn't be much need for ballot initiatives, taxpayer revolts, or fear-mongering talk of pension bankruptcies. We could cut the unfunded liabilities dramatically to manageable levels in most states.

Pension reformers on the opposing side would do themselves a favor by giving up the mythical "mandatory 401(k) solution" and focusing their efforts on hybrid plans that retain a modest, capped pension benefit that can be supplemented with defined contribution payments for earnings above the average household income (about $50,000 nationwide, higher in most states with big pension problems). It's called "cap and stack" (for the stacking of a defined contribution plan on top of a capped pension) for those making more than the earnings limit; this was conceptually suggested by a prominent academic authority who's quoted by a prominent public-sector advocacy organization.

This plan design would eliminate the pension spiking scandals and close out the "$100,000 pension club" membership. With this one single reform, public managers would hereafter separate their personal interests from the unions they face at the bargaining table. Police and firefighters can receive defined contribution benefits for their overtime without spiking their pensions. A hybrid plan like this would share investment risks between taxpayers and the higher-paid employees without increasing risks assigned to those least able to afford them.

Personally, I could live with a pension cap of 1.5 times the median household income. But I understand reformers who insist that taxpayers shouldn't support guaranteed lifetime incomes above the average taxpaying household. Beyond that level, the benefits are no longer about retirement security and keeping public employees off welfare. Jumbo pensions are really deferred compensation and should be structured as such using defined contribution plans.

New public employees should be given a defined contribution retiree health savings option to enable them to save sufficiently to cover those costs in retirement. Any defined benefits for retirement medical purposes should be limited to those similar to the Denver city employees' plan, which is $12.50 per month per year of service. That formula is actuarially affordable at the level of 1 percent of salary. My previous column on affordable OPEB benefits explains how to do this.

Pension reformers should also support the two collective bargaining reforms I suggested above for modifying and rationalizing benefits of incumbents. If the unions won't join a coalition to accept such changes in a collective bargaining environment allowed by statute, then the pension reformers have every right to insist upon them as a unilateral employer right by ballot initiative.

Funding fixes. Finally, the pension reformers, civic associations and pension advocates all should insist on prudent and systematic funding of retirement benefits. No pension holidays. Public employees should pay at least half the normal cost of their benefits unless their cash pay is correspondingly below private employees in the labor markets from which they are recruited. Sustainable funding practices must prohibit costs being shifted to future generations of taxpayers through extended amortization periods that exceed workers' remaining career spans, and ban actuarial smoothing beyond the duration of a typical business cycle (6 years on average since 1926). These changes can be accomplished by statute or plan policies with a five-year phase-in period

Of course there are other issues and axes to grind, including governance, but everything else is noise, folks. Pension abuses can be cured. Benefits can be reformed to achieve sustainable levels. We just need to focus on what moves the dial the most and the fastest for the employers who most need corrective measures. Let's not punish the innocent. The sooner that true leaders in the center reach out to battling partisans, the sooner we can fix this mess. Let's play on.